Koç University

ECON 450 / Fall 2023

Alper Yılmaz

Homework Assignment #1 (due by October 26, 2023 – 12:30PM)

Question 1 – Production externalities (40 points)

In this question we will derive the first-order conditions for production externalities
using two firms.
Suppose firm 𝑌 produces some amount of yarn, 𝑦, and also produces a certain amount
of pollution, 𝑥, which it dumps into a river. Firm 𝐵, a brewery, is located downstream
and is adversely affected by 𝑌’s pollution, as it uses the water from the river in its
brews.
Suppose that firm 𝑌’s cost function is given by 𝑐! (𝑦, 𝑥), where 𝑦 is the amount of yarn
produced and 𝑥 is the amount of pollution produced. Firm 𝐵’s cost function is given by
𝑐" (𝑏, 𝑥), where 𝑏 indicates the production of beer and 𝑥 is the amount of pollution. Note
that 𝐵’s costs of producing a given amount of beer depend on the amount of pollution
produced by the yarn mill. We will suppose that pollution increases the cost of brewing
beer 𝛥𝑐" /𝛥𝑥 > 0, and that pollution decreases the cost of yarn production, 𝛥𝑐! /𝛥𝑥 ≤ 0.
This last assumption says that increasing the amount of pollution will decrease the cost
of producing yarn—that reducing pollution will increase the cost of yarn production, at
least over some range. Suppose the market price of yarn is 𝑝! and beer is 𝑝" . Assume
pollution has a zero price.
a. (10 points) Write down the yarn mill’s and the brewery’s profit-maximization
problems.
b. (10 points) Write down the first-order conditions characterizing profit
maximization for the yarn mill and the brewery. Interpret these conditions.
Specifically, focus on how much pollution the yarn mill would produce.
c. (10 points) Suppose that the two firms merged and formed one firm that
produced both yarn and beer (and pollution). The externality has been
internalized by this reassignment of property rights. Write down the merged
firm’s profit-maximization problem.
d. (10 points) Write down the profit-maximizing first-order conditions of the
merged firm. Interpret these conditions. Specifically, focus on the condition that
determines the amount of pollution. Interpret.

Question 2 – Taxation of pollution (30 points)

Now let’s go back to the two-separate-firms scenario in Question 1. Suppose now the
government puts a tax of 𝑡 dollars, a Pigouvian tax, per unit of pollution generated by
the yarn mill.
a. (10 points) Write down the profit-maximization problem of the yarn mill.
b. (10 points) Write down the first-order conditions characterizing profit
maximization for the yarn mill.
c. (10 points) Using the first-order condition you found for the merged firm in
Question 1(d), find the tax amount in terms of damages to the brewery.
Question 3 – Market for pollution (30 points)
Suppose the brewery in the previous two questions has the right to clean water, but
could sell this right to allow pollution. Let 𝑞 be the price of unit of pollution and let 𝑥 be
the amount of pollution the yarn mill produces.
a. (10 points) If the yarn mill buys pollution rights from the brewery, what is its
profit-maximization problem?
b. (10 points) What’s the brewery’s profit maximization problem?
c. (10 points) What are the profit-maximization conditions? What can you say
about marginal cost of reducing pollution to the yarn mill and marginal benefit to
the brewery?